Taxation 2

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Taxation 2

• Economics of Public Policy
• PADM 625
• Ben Muse

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Impact on competitive markets
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Supply curve
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Market output and price
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Suppose we impose an excise tax on consumers

• Per unit excise tax on bagels
• imposed on consumers
• when they purchase a bagel a tax is rung up on
  cash register along with the sellers price

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Excise tax on consumers

• The demand curve shows the maximum price the
  consumers are willing to pay for any given unit
  (gross price)
• The demand curve, net of the tax, shows the curve
  as perceived by the sellers

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Gross and Net demand curves
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Price and quantity before the tax
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Impact of the tax
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Impact

• Price paid by consumers increases
• but by less than the amount of the tax
• the producer pays part of the tax as well
• Quantity declines

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Tax equivalence
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Tax equivalence

• Suppose the same tax was imposed on bagels
• But the government collected directly from the
  bagel producers?

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Heres the tax on consumers
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Suppose the sellers rather than the buyers paid?
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Doesnt matter who pays

• Same change in level of output
• Same new market price for the output
• Same distribution of the tax burden

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Superimpose both payer curves
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Implications for Social Security tax

• Tax financing Social Security and Medicare
• Split between workers and employers
• Each pays half (7.65)

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Implications for Social Security tax

• Tax equivalence argument says that this doesnt
  matter
• How the tax is split should have no impact on
• labor costs to employers
• take home pay for workers
• level of employment

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Tax incidence
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Incidence of excise tax

• Depends on relative steepness of the supply and
  demand curves
• That is, the incidence depends on the relative
  elasticities of the supply and demand curves
• (price elasticity is the percentage change in
  quantity demand (or supplied) for a given
  percentage change in price)

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Incidence of excise tax

• In this example we will impose a specific ( per
  unit) excise tax
• This excise tax will be paid by consumers
• The incidence will depend on the steepness of
  the supply curve (well keep the demand curve
  constant)

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Bagel market
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Perfectly elastic Supply curve
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Add in demand curve
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Impose excise tax
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Price increase- buyer pays
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Perfectly inelastic supply
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Market price
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Add in the after tax demand
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Taxing a price-setter
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Price setter

• Monopolist
• or a firm with market power
• Faces a downward sloping demand curve
• and chooses the profit maximizing combination of
  price and output
• these are not independent choices

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Price setter

• The price setter will do so by equating marginal
  revenue and marginal cost
• but marginal revenue calculation is more complex
  than when firm faced constant price

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Price setter

• Now, selling an additional unit lowers price
• a firm gets the lower price on the additional
  unit
• but also gets the lower price on all the units it
  was already selling
• marginal revenue will be less than the price on
  the new unit sold

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MC, D, and MR curves
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Optimal level of output
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The price at that level of output
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Monopoly profits
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Imposing the tax
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New monopoly profits
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Impact

• Monopolist reduces output
• Increases price
• but not by full amount of the tax
• Increases price by less than a competitive
  industry would have (although this result depends
  on the form of the demand curve)

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Tax rates and tax revenues
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Rates and revenues

• Concern over amount of revenue raised by the tax
• Revenues may rise and fall as rates rise
• At low rates there is lots of taxed economic
  activity

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Extra revenue from higher rate vs lost revenue
from smaller base
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In the previous slide

• The yellow shaded area is the extra revenue from
  raising the excise tax from t1 to t2

• The green shaded area is the lost revenue when
  the excise tax increase from t1 to t2 shrinks the
  tax base

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Rate and revenue tradeoff

• An increase in rates falls on lots of
  transactions (more revenue)
• Discourages a few (offsetting)
• As rates rise, fewer transactions
• Increase in rates falls on fewer transactions
  (less additional revenue)
• Discouraged transactions continues to offset

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Rates and revenues

• At high rates, relatively few transactions
• An increase in rates falls on relatively few
  transactions
• And continues to discourage transactions

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Revenue curve
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Revenue curve
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Source

• Bruce, Chapter 10
• Stiglitz, Joseph. Economics of the Public
  Sector. 3d edition. Norton, 2000.